Beyond track record, investors tell us that it is a GP’s team size and investment capacity that currently dominates due diligence, followed closely by terms and fees benchmarking and succession and retention planning at the GP level.
In Private Debt Investor’s LP Perspectives 2022 Study, it is also clear that the evidence and consideration of ESG is now of rapidly growing importance, forming a major part of due diligence for 57 percent of GPs, when it was described as such by only 31 percent of investors as recently as 2020.
In the past two years, the number of LPs paying no attention to the ESG credentials of managers has fallen from one in five to fewer than one in 10, as the investor community pushes this topic up the agenda.
Within ESG, we also see a growing focus from investors on diversity and inclusion at the GP level. In 2019, we asked LPs whether a manager’s gender pay gap at GP level factored into due diligence, and 57 percent were not covering the topic. Today, evidence of diversity and inclusion is a part of due diligence for 85 percent of managers.
Blair Jacobson, partner and co-head of European Credit in the Ares Credit Group and a member of the Ares Executive Management Committee, told PDI in December that LP interest in ESG has escalated rapidly in recent years: “We raised our third European direct lending fund in 2015 and that was the first time we had a specific diligence questionnaire about our ESG policies.
“It’s accelerated significantly since then. When we raised our fifth fund [in 2021], we had ESG discussions with every investor and many LPs wanted follow-up sessions to go into more detail. LP expectations have continued to scale and what started in the Nordics is now a focus for everyone.”
At Bridgepoint Credit, whose parent Bridgepoint owns Private Debt Investor publisher PEI Media, deputy managing partner Hamish Grant says there is also intensifying interest from LPs around diversity and inclusion: “If you look at the investor community, there’s the same breadth of focus on D&I as there is on ESG,” he says. “ESG has become a hot topic for a lot of investors and diversity and inclusion is a key part of that.”
Adinah Shackleton, head of ESG at Permira, says: “LP expectations have really shifted in recent years and in many ways are now similar to those that we see on the private equity side of the business. There is obviously a different relationship with the underlying company in the context of credit, but the expectations are very much the same.”
When asked about the activities that require the greatest amount of their time, investors say they devote significant time to fund due diligence and portfolio monitoring. Only one in 10 LPs are spending a lot of time on policy development around considerations such as ESG. Researching new GPs also remains a low priority, getting significant time commitment from fewer than one in four investors.
Source for disagreement
When it comes to the fund terms causing most disagreement between GPs and their investors during due diligence, management fees and unsatisfactory or non-existent key man clauses remain the biggest areas of contention. Both of these issues are identified as a cause of disagreement by a growing number of LPs over time, as are debates around the structure of carry distribution and investment restrictions.
Lawyers say LPs are increasingly looking for much tougher provisions to come down hard on GPs for unresolved key-person events, in some cases calling for a loss of carried interest as they grapple with anxieties about losing key talent. More common is a push to reduce the management fee if a key-person event triggers a suspension of the investment period, with investors demanding an immediate step-down in the management fee calculation without waiting to see if the key-person event can be remedied.
Key-person clauses are also being extended to cover more people. Geoffrey Kittredge, partner and chair of Debevoise & Plimpton’s European funds and investment management practice, told PDI last year that “key-person clauses started off with just one or two people but, as firms develop, the key-person trigger becomes more complex and more about teams or combinations of senior and mid-level executives and investment professionals. That’s natural and will continue”.
Meanwhile, the level of GP commitment, hurdle rates and set up costs are no longer as contentious in LPA due diligence as they were in the past, and board representation is a hot issue for one in 10 investors, in line with where it has been for some time.
Jeffrey Griffiths, co-head of global private credit at placement agent Campbell Lutyens, says: “Leverage levels are a big talking point in due diligence at the moment, with LPs focusing on how much leverage is really acceptable on deals and seeking to understand debt to EBITDA ratios and how stretched those are. That is a big topic for discussion.
“There is also still a huge focus on how managers traded through the pandemic, with investors very keen and very able to due diligence those track records in some detail.”